Banks ‘need more capital’ - but when?

The Bank of England's Financial Policy Committee will tomorrow provide more enlightenment on a question of serious importance to the banks, the government and all of us - which is how much additional capital the banks need to raise, and when, to cover the risk of losses on loans to borrowers who may struggle to repay.

For what it is worth, I have been told two seemingly contradictory things.

First that the FPC - set up by the government to pre-empt and prevent future financial crises - will be explicit that the banks need to build up their capital buffers, to cover the "general" risk of a future "general" spike in losses.

The important technical point - as you may have noticed by my annoyingly liberal use of speech marks - is that these are "general" capital buffers, or capital that is additional to what banks are forced to hold by Pillar 1 of the Basel rules (oh yes) to cover the measurable risk of loss on "specific" loans (and bravo to those of you resolutely wading through this stuff - I would argue it matters to all of us, because it goes to the heart of whether banks are strong enough to support the needs of the economy).

Second, any such pronouncement by the FPC won't lead to taxpayers being forced to put yet more money into Royal Bank of Scotland or Lloyds - or at least not immediately, in any case (such are the noises from the Treasury, which really ought to know what's going on).

Now it is not clear to me how these two statements can be consistent.

Because if RBS, for example, is forced along with the other banks to reinforce its capital buffers to a significant extent, it is difficult to see where this capital can come from, if not taxpayers: with RBS 80% owned by the state, and with its share price still relatively low, the bank could not raise significant sums of equity from conventional investors.

So, to state the obvious, there is obviously something I don't know about what the FPC will say tomorrow.

Perhaps the FPC will initiate a formal process of assessing each bank, to verify whether in this general sense they have enough spare capital to absorb potential losses on loans more susceptible to being significantly impaired as and when borrowers face hardship.

Now arguably the most resonant and important category of such loans are those in forbearance or on the cusp of forbearance. These are debts where the banks have temporarily eased payment terms - perhaps by making them interest-only debts or by rolling up the interest into the principal - because borrowers are seen to be facing temporary financial hardship.

Research by the Financial Services Authority indicated that between 5% and 8% of mortgages are in forbearance together with a third of commercial real estate loans.

Of course, the banks have already set aside incremental capital against loans in forbearance. But it is not clear whether they have made adequate provision for the worst that could happen.

To put it another way, there are tens of billions of pounds of loans made by British banks, whose quality is low and where there is a higher-than-average probability that they will never be repaid in full. And the question haunting the regulators and investors is whether banks hold enough capital to withstand the losses, just in case a big proportion of loans in forbearance have to be written off.

But there would be something of a problem with a review of whether individual banks have adequate general protection. It could be a messy and elongated process, and could have precisely the opposite consequence to that desired by the FPC - because it could encourage banks to stop lending, to the detriment of the economy, as they attempt to massage up the ratio of their capital to assets.

As it happens, the earlier pronouncements of FPC members would indicate they would prefer a short, sharp shock of rapid capital raising - either through banks asking their owners and other investors for more money or the banks selling businesses worth more than their book value.

Why? Well the big point of forcing banks to increase their capital buffers would be to give them confidence that they have protection against whatever storms lie ahead - so that they would not have to be so penny-pinching and reluctant to provide the loans badly needed by healthy businesses and households.

Or to put it another way, it would once-and-for-all put to bed the notion that some of our banks are in effect "zombies" - with enough capital to just about keep going, but not enough to fulfil their essential function of creating the credit necessary for the UK's economic recovery.

But, again, to expose the glaring gaps in my knowledge, if the FPC announces such a short sharp shock of capital raising, it is very difficult to see how that can be done without RBS in particular - and perhaps Lloyds too - becoming even more nationalised than they are.

And that is something the Treasury neither expects or wants.

So it is all a bit puzzling.

By way of postscript, however, there is an important philosophical point here, which is that the FPC wants the banks to be less mechanistic in the determination of their respective capital needs and to exercise more judgement.

This would represent a cultural revolution, a process of going back to the future, because bankers would have to put at the forefront of everything they do not the maximisation of short-term profit as a percentage of capital, but the reinforcement of the foundations of their institutions to withstand more-or-less any earthquake.